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Least-Squares Regression Method

Least-squares linear regression is a statistical technique that may be used to estimate the total cost at the given level
of activity (units, labor/machine hours etc.) based on past cost data. It mathematically fits a straight cost line over a
scatter-chart of a number of activity and total-cost pairs in such a way that the sum of squares of the vertical
distances between the scattered points and the cost line is minimized. The term least-squares regression implies that
the ideal fitting of the regression line is achieved by minimizing the sum of squares of the distances between the
straight line and all the points on the graph.
Assuming that the cost varies along y-axis and activity levels along x-axis, the required cost line may be represented
in the form of following equation:
y = a + bx
In the above equation, a is the y-intercept of the line and it equals the approximate fixed cost at any level of activity.
Whereas b is the slope of the line and it equals the average variable cost per unit of activity.

Formulas
By using mathematical techniques beyond the scope of this article, the following formulas to calculate a and bmay be
derived:
Unit Variable Costbnxyxynx2x2
Total Fixed Costaybxn
Where,
n is number of pairs of unitstotal-cost used in the calculation;
y is the sum of total costs of all data pairs;
x is the sum of units of all data pairs;
xy is the sum of the products of cost and units of all data pairs; and
x2 is the sum of squares of units of all data pairs.
The following example based on the same data as in high-low method tries to illustrate the usage of least squares
linear regression method to split a mixed cost into its fixed and variable components:

Example
Based on the following data of number of units produced and the corresponding total cost, estimate the total cost of
producing 4,000 units. Use the least-squares linear regression method.

Month

Units

Cost

1
2
3
4
5
6
7
8

1,520
1,250
1,750
1,600
2,350
2,100
3,000
2,750

$36,375
38,000
41,750
42,360
55,080
48,100
59,000
56,800

Solution:

x
1,520
1,250
1,750
1,600
2,350
2,100
3,000
2,750
16,320
We have,
n = 8;

x2

y
$36,375
38,000
41,750
42,360
55,080
48,100
59,000
56,800
377,465

2,310,400
1,562,500
3,062,500
2,560,000
5,522,500
4,410,000
9,000,000
7,562,500
35,990,400

xy
3,511,808,000
1,953,125,000
5,359,375,000
4,096,000,000
12,977,875,000
9,261,000,000
27,000,000,000
20,796,875,000
84,956,058,000

x = 16,320;
y = 377,465;
x2 = 35,990,400; and
xy = 84,956,058,000
Calculating the average variable cost per unit:
b884,956,058,00016,320377,465835,990,40016,320213.8
Calculating the approximate total fixed cost:
a377,46513.807816,320819,015
The cost-volume formula now becomes:
y = 19,015 + 13.8x
At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8 4,000].

High-Low Method
High-Low method is one of the several techniques used to split a mixed cost into its fixed and variable components
(see cost classifications). Although easy to understand, high low method is relatively unreliable. This is because it only
takes two extreme activity levels (i.e. labor hours, machine hours, etc.) from a set of actual data of various activity
levels and their corresponding total cost figures. These figures are then used to calculate the approximate variable
cost per unit (b) and total fixed cost (a) to obtain a cost volume formula:

y = a + bx

High-Low Method Formulas


Variable Cost per Unit
Variable cost per unit (b) is calculated using the following formula:

y2 y1
Variable Cost per Unit =
x2 x1

Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
The variable cost per unit is equal to the slope of the cost volume line (i.e. change in total cost change in number of
units produced).

Total Fixed Cost


Total fixed cost (a) is calculated by subtracting total variable cost from total cost, thus:

Total Fixed Cost = y2 bx2 = y1 bx1

Example
Company wants to determine the cost-volume relation between its factory overhead cost and number of units
produced. Use the high-low method to split its factory overhead (FOH) costs into fixed and variable components and

create a cost volume formula. The volume and the corresponding total cost information of the factory for past eight
months are given below:

Month

Units

FOH

1,520

$36,375

1,250

38,000

1,750

41,750

1,600

42,360

2,350

55,080

2,100

48,100

3,000

59,000

2,750

56,800

Solution:
We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 $38,000) (3,000 1,250) = $12 per unit
Total Fixed Cost = $59,000 ($12 3,000) = $38,000 ($12 1,250) = $23,000
Cost Volume Formula: y = $23,000 + 12x
Due to its unreliability, high low method is rarely used. The other techniques of variable and fixed cost estimation are
scatter-graph method and least-squares regression method.

Break-even Point Equation Method


Break-even is the point of zero loss or profit. At break-even point, the revenues of the business are equal its total
costs and its contribution margin equals its total fixed costs. Break-even point can be calculated by equation
method, contribution method or graphical method. The equation method is based on the cost-volume-profit
(CVP) formula:

px = vx + FC + Profit

Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.

Calculation

BEP in Sales Units


At break-even point the profit is zero therefore the CVP formula is simplified to:

px = vx + FC

Solving the above equation for x which equals break-even point in sales units, we get:

FC
Break-even Sales Units = x =
pv

BEP in Sales Dollars


Break-even point in number of sales dollars is calculated using the following formula:

Break-even Sales Dollars = Price per Unit Break-even Sales Units

Example
Calculate break-even point in sales units and sales dollars from following information:

Price per Unit

$15

Variable Cost per Unit


Total Fixed Cost

$7
$9,000

Solution
We have,
p = $15
v = $7, and
FC = $9,000
Substituting the known values into the formula for breakeven point in sales units, we get:
Breakeven Point in Sales Units (x)
= 9,000 (15 7)
= 9,000 8
= 1,125 units
Break-even Point in Sales Dollars = $15 1,125 = $16,875

Sales Mix Break-even Point Calculation


Sales mix is the proportion in which two or more products are sold. For the calculation of break-even point for sales
mix, following assumptions are made in addition to those already made for CVP analysis:
1.

The proportion of sales mix must be predetermined.

2.

The sales mix must not change within the relevant time period.

The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we
have multiple products in sales mix therefore it is most likely that we will be dealing with products with different

contribution margin per unit and contribution margin ratios. This problem is overcome by calculating weighted average
contribution margin per unit and contribution margin ratio. These are then used to calculate the break-even point for
sales mix.
The calculation procedure and the formulas are discussed via following example:

Example: Formulas and Calculation Procedure


Following information is related to sales mix of product A, B and C.

Product

$15

$21

$36

Variable Cost per Unit

$9

$14

$19

Sales Mix Percentage

20%

20%

60%

Sales Price per Unit

Total Fixed Cost

$40,000

Calculate the break-even point in units and in dollars.

Calculation
Step 1: Calculate the contribution margin per unit for each product:

Product

$15

$21

$36

Variable Cost per Unit

$9

$14

$19

Contribution Margin per Unit

$6

$7

$17

Sales Price per Unit

Step 2: Calculate the weighted-average contribution margin per unit for the sales mix using the following formula:
Product A CM per Unit Product A Sales Mix Percentage
+ Product B CM per Unit Product B Sales Mix Percentage
+ Product C CM per Unit Product C Sales Mix Percentage
= Weighted Average Unit Contribution Margin

Product

$15

$21

$36

Variable Cost per Unit

$9

$14

$19

Contribution Margin per Unit

$6

$7

$17

20%

20%

60%

$1.2

$1.4

$10.2

Sales Price per Unit

Sales Mix Percentage

Sum: Weighted Average CM per Unit

$12.80

Step 3: Calculate total units of sales mix required to break-even using the formula:
Break-even Point in Units of Sales Mix = Total Fixed Cost Weighted Average CM per Unit

Total Fixed Cost


Weighted Average CM per Unit

$40,000
$12.80

Break-even Point in Units of Sales Mix

3,125

Step 4: Calculate number units of product A, B and C at break-even point:

Product
Sales Mix Ratio
Total Break-even Units
Product Units at Break-even Point

20%

20%

60%

3,125

3,125

3,125

625

625

1,875

Step 5: Calculate Break-even Point in dollars as follows:

Product

Product Units at Break-even Point

625

625

1,875

Price per Unit

$15

$21

$36

$9,375

$13,125

$67,500

Product Sales in Dollars


Sum: Break-even Point in Dollars

$90,000

Written by Irfanullah Jan

Payback Period
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash
inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Formula
The formula to calculate payback period of a project depends on whether the cash flow per period from the project is
even or uneven. In case they are even, the formula to calculate payback period is:

Payback Period =

Initial Investment
Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the
following formula for payback period:

Payback Period = A +
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.

Decision Rule
Accept the project only if its payback period is LESS than the target payback period.

Examples

B
C

Example 1: Even Cash Flows


Company C is planning to undertake a project requiring initial investment of $105 million. The project is expected to
generate $25 million per year for 7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of $50 million and is expected to
generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in
Year 5. Calculate the payback value of the project.
Solution

(cash flows in
Cumulative
millions)
Cash Flow
Year
Cash Flow
0
(50)
(50)
1
10
(40)
2
13
(27)
3
16
(11)
4
19
8
5
22
30
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years

Advantages and Disadvantages


Advantages of payback period are:
1.

Payback period is very simple to calculate.

2.

It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are
considered more uncertain, payback period provides an indication of how certain the project cash inflows are.

3.

For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

Disadvantages of payback period are:


1.

Payback period does not take into account the time value of money which is a serious drawback since it can
lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted
payback period method.

2.

It does not take into account, the cash flows that occur after the payback period.

Written by Irfanullah Jan

Discounted Payback Period


One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this
limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value
of money by discounting the cash inflows of the project.

Formulas and Calculation Procedure


In discounted payback period we have to calculate the present value of each cash inflow taking the start of the first
period as zero point. For this purpose the management has to set a suitable discount rate. The discounted cash inflow
for each period is to be calculated using the formula:

Discounted Cash Inflow =

Actual Cash Inflow


(1 + i)n

Where,
i is the discount rate;
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are actual cash inflow and present value factor ( i.e. 1 /
( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow and present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we have to use the
discounted cash flows as calculated above instead of actual cash flows. The cumulative cash flow will be replaced by
cumulative discounted cash flow.

Discounted Payback Period = A +

Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an alternative formula for situations where all the cash
inflows were even. That formula won't be applicable here since it is extremely unlikely that discounted cash inflows
will be even.
The calculation method is illustrated in the example below.

Decision Rule
If the discounted payback period is less that the target period, accept the project. Otherwise reject.

Example
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted
payback period of the investment if the discount rate is 11%.
Solution
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by
present value factor. Create a cumulative discounted cash flow column.

Year
n

Cash Flow
CF

Present Value Factor


PV$1=1/(1+i)n

Discounted Cash
Flow
CFPV$1

Cumulative Discounted
Cash Flow

$
2,324,000

1.0000

$ 2,324,000

$ 2,324,000

600,000

0.9009

540,541

1,783,459

600,000

0.8116

486,973

1,296,486

600,000

0.7312

438,715

857,771

600,000

0.6587

395,239

462,533

600,000

0.5935

356,071

106,462

600,000

0.5346

320,785

214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years

Advantages and Disadvantages


Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of
money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the payback period.
Written by Irfanullah Jan

Sales Budget
Sales budget is the first and basic component ofmaster budget and it shows the expected number of sales units of a
period and the expected price per unit. It also shows total sales which are simply the product of expected sales units
and expected price per unit.
Sales Budget influences many of the other components of master budget either directly or indirectly. This is due to the
reason that the total sales figure provided by sales budget is used as a base figure in other component budgets. For
example the schedule of receipts from customers, the production budget, pro forma income statement, etc.
Due to the fact that many components of master budget rely on sales budget, the estimated sales volume and price
must be forecasted with sufficient care and only reliable forecast techniques should be employed. Otherwise the
master budget will be rendered ineffective for planning and control.

Format and Example


Where the price per unit is expected to remain constant during the period for all units in sales, the sales budget
format will be simple as shown below.

Company A
Sales Budget
For the Year Ending December 30, 2010

Quarter
1
Sales Units
Price per Unit
Total Sales

Year

1,320

954

1,103

1,766

$91

$92

$97

$112

$120,120

$87,768

$106,991

$197,792

5,143

$512,671

However if a business sells more than one product having different prices or the price per unit is expected to change
during the period, its sales budget will be detailed.
Written by Irfanullah Jan

Production Budget

Production budget is a schedule showing planned production in units which must be made by a manufacturer during a
specific period to meet the expected demand for sales and the planned finished goods inventory. The required
production is determined by subtracting the beginning finished goods inventory from the sum of expected sales and
planned ending inventory of the period. Thus:
Planned Produciton in Units
= Expected Sales in Units
+ Planned Ending Inventory in Units
Begining Inventory in Units
Production budget is prepared after sales budgetsince it needs the expected sales units figure which is provided by the
sales budget. It is important to note that only a manufacturing business needs to prepare the production budget.

Format and Example


The following example illustrates the production budget format. The expected sales units are obtained from the sales
budget of Company A. The planned ending units of 1st, 2nd and 3rd period are the beginning units in 2nd, 3rd and
4th period respectively.

Company A
Production Budget
For the Year Ending December 30, 2010

Quarter
1
Budgeted Sales Units

Year

1,320

954

1,103

1,766

5,143

210

168

213

225

225

Beginning Units

196

210

168

213

196

Planned Production in Units

1,334

912

1,148

1,778

5,172

+ Planned Ending Units

Written by Irfanullah Jan